An introduction to U.S. macroeconomic policy issues, such as how we use monetary and fiscal policies to promote economic growth, low unemployment, and low inflation.

Monday, December 21, 2009

How reliable are recommendations for buying individual stocks? You will probably be better off buying an index mutual fund.

In the December 21, 2009 Wall Street Journal article "'Hot Stocks For a New Decade?' Wait a Minute!," Brett Arends explains that the alleged experts at picking individual stocks that will perform well in the future do not have a reliable record.

Hands up if you had Southwestern Energy.

No? How about XTO Energy? Range Resources? Precision Castparts?

You should have. These were top stocks of the decade in the Standard & Poor's 500-stock index. Ten years ago, the smartest thing you could have done with your money was to invest in these. Each $1,000 invested then would be worth tens of thousands today.

Now look at the stocks the experts told you to buy instead.

The most widely recommended -- according to a quick survey at the time in the Washington Post -- were America Online, Cisco Systems, Qualcomm, MCI WorldCom, Lucent Technology and Texas Instruments.

Ahem.

Any people who invested in that portfolio have lost about two-thirds of their money. The average stock picked at random was up 3%, including dividends.

Beware of 'Disaster' Picks

Money Magazine's "The Best Investments for 2000 and Beyond": down about a fifth.

The SmartMoney/Wall Street Journal Sunday picks fell by about a half. The list was heavily weighted toward technology, and most stocks plummeted. MCI WorldCom and Nortel Networks ended up in Chapter 11.

OK, it's easy to poke fun. But it's something to think about -- especially around this time of year, when wise men once again come bearing stock tips.

The embarrassments don't stop there. Investors have just endured an absolutely terrible 10 years -- a string of crashes, crises, financial scandals, recessions and collapsed bubbles.

According to Standard & Poor's analyst Howard Silverblatt, it has actually been the worst decade for U.S. investors on record. When you look at total returns, including dividends, we've even done worse than the 1930s. Investors in the S&P 500 have lost about 10% this decade.

After you count inflation, investors have actually lost about 30%. That's even behind the inflationary 1970s, when investors lost about 23% in real terms.

And that's if you managed to hang on. Those shaken out during the crashes of 2001-2003 and 2007-2009 may have done much worse.

The Nasdaq Composite fell about three quarters from its peak, and, of course, many technology stocks were wiped out altogether. But how much warning did investors get from the pros? Almost none.

When Barron's, our sister publication, held its annual investment roundtable in January 2000, just two of the 10 major Wall Street figures who took part warned investors about a looming bear market. This was just three months before the Nasdaq reached its all-time high -- which is still more than double where it stands today.

Avoid 'Coffee-Cart' Tipsters

One fund manager admitted to Barron's that "I have a guy who sells me coffee in the morning, who grew up in Bombay, and he is more into the stock market than I am," echoing those infamous tales of stock tips from shoe-shine boys just before the Crash of 1929. Yet even that ominous sign wasn't enough to turn the group bearish. Instead Goldman Sachs strategist Abby Cohen said the stock market was "roughly at fair value based upon our view of S&P profits." Even technology stocks were "not overvalued" based on standard measures, she insisted.

Hubris, meet schadenfreude. Face, meet egg.

(Goldman Sachs notes that Ms. Cohen did turn more cautious some months later, near the peak.)

Ten years later, some things have changed on Wall Street. But plenty hasn't.

Much of the stock-market community is still just a marketing machine that happens to sell investments, the way, say, a drugstore like CVS sells pills. (Unfair? Just a little: CVS, after all, won't deliberately sell you bad pills.)

Investors, forewarned after the last 10 years, are better forearmed ahead of the next 10. Anyone seeking to protect his or her money needs to correct for the biases of the financial industry.

The most powerful and dangerous force on Wall Street is the herd instinct. Look out.

It's easy and safe for most "investment professionals" to stick together and recommend the same things, no matter how foolish. It's better -- for them, though perhaps not for the clients -- to be wrong in a crowd than risk standing alone. Few things are more dangerous to investors than a consensus.

And there is, of course, generally a strong bullish bias on Wall Street. Even today, as usual, most stock recommendations are positive. Never mind that the market is already nine months into a recovery that has seen the S&P 500 rise more than 63% and the Nasdaq jump over 70%. (And all the while, 17% of the country is unemployed, underemployed or has stopped looking for work.)

No matter how overvalued a stock, an analyst can always be found to say it's cheap compared to some other (even more overvalued) stock. This was common during the dotcom bubble.

It hasn't gone away. And no matter how dangerous markets may be, someone will always warn you -- just as they did in 1999 -- to stay fully invested because "you can't time the market." That this advice happens to be in their interests is, of course, mere happenstance.

Don't Chase Highflying Stocks

These days investors have relearned that the investments everyone is talking about are usually ones you don't want to buy. The risks of chasing a highflier generally outweigh the rewards. It takes a 100% profit to recover from a 50% loss.

The best investments are usually the ones nobody is talking about. Ten years ago, everybody was talking about which technology stocks to buy. Almost nobody was talking about gold. The Bank of England could barely give the stuff away at $260 an ounce.

As I've poked fun at others' poor foresight, I had better 'fess up to my own, too. Ten years ago, a money manager friend repeatedly urged me to sell everything and buy gold.

Did I listen? Don't ask.

Write to Brett Arends at brett.arends@wsj.com

Your Money: A To-Do List

Looking for money tips for the next decade? Here are a half dozen:

1. Pay off your credit cards already. Then cut them up. Obvious but true. That saves you 15% or more. A cert to beat the market.

2. Slash your taxes. They're only heading in one direction. Make the full use of your 401(k) and IRA allowances each year. If you have children, save in a 529 college-savings plan too.

3. Run the numbers on buying a home. Real estate has plunged, and fixed-rate mortgages look cheap below 5%. Do the math to see if owning now makes more sense than renting.

4. Weed out your high-fee mutual funds. Most funds charge a bundle: Few are worth it. Unless a fund is exceptional, you're better off in a low-cost index fund.

5. Check your inflation risk. Long-term bonds, including Treasurys, corporates and municipals, are all at risk if these deficits lead to higher inflation down the road, as many fear.

6. Looking for a wager? Try the iShares MSCI Japan Index exchange-traded fund (EWJ). At the start of the new decade, the Tokyo stock market may be the world's least fashionable investment.

You Want the Truth?

Comments

I welcome comments. Please keep them civil, short and to the point. Obscene, profane, abusive and off topic comments will be deleted. Repeat offenders will be blocked. Thanks for taking part — and abiding by these simple rules.

The following information is provided to help you understand the biases that may be inherent in this blog.My primary U.S. economic policy concern is the fiscal irresponsibility of government.The Baby Boom generation, which I am part of, has spent the past 30 years accumulating massive public debt that will be passed to our children, grandchildren, and subsequent generations.I am not opposed to the reduction or elimination of any government spending program.Yet, politicians tend to call for reduced spending in general terms and fail to publicly declare specific cuts they would make.The primary cause of the massive U.S. public debt is revenue reductions (in the form of tax cuts) without similar decreases in government spending.

I am willing to consider the expansion and addition of government programs as well.I do not mind how much or little the government provides to society as long as it is paid for.I am willing to pay higher taxes for services deemed worthy, whether they be national defense, homeland security, or income assistance to those less fortunate than I.And I am certainly willing to pay less in taxes or to deposit any government check I receive.My generation, the Baby Boomers, has been very good at cutting taxes and increasing the size of government, regardless of which political party is in power.This is a prescription for financial chaos that remains a horrible legacy for future generations.

About Me

I am a professor of economics at Jacksonville University, where I teach courses in introductory economics, comparative economic development, and globalization. I use this blog to keep in touch with my current and former students. Teachers and students at other schools, as well as others interested in economic issues, are welcome to use this resource.